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Saturday, September 6, 2014

Stocks generally added to recent gains. For the week, the Dow and S&P500 gained about 1%. The Transports added 0.6%, while the Utilities were about unchanged. The Morgan Stanley Cyclical and Morgan Stanley Consumer indices added 1%. The broader market gained as well, with the small cap Russell 2000 and S&P400 Mid-cap indices up about 1%. The technology rally continued. For the week, the NASDAQ100 and Morgan Stanley High Tech indices gained less than 2%. The Semiconductors actually declined 1%, while The Street.com Internet Index added 2% and the NASDAQ Telecommunications index gained 1.4%. The Biotechs jumped 2.5%. Financial stocks were strong, with the Broker/Dealers up 2% and the Banks up better than 1%. With bullion sinking $9.70, the HUI index declined 2%.

The Treasury market continues to trade well. For the week, 2-year Treasury yields added 2 basis points to 2.45%. Five-year Treasury yields were up 2 basis points to 3.43%. Ten-year yields were unchanged at 4.23%. Long-bond yields ended today's session at 5.03%, down 1 basis point on the week. Benchmark Fannie Mae MBS yields were unchanged, in line with Treasuries. The spread (to 10-year Treasuries) on Fannie’s 4 3/8% 2013 note narrowed 1 to 31, and the spread on Freddie’s 4 ½ 2013 note was about unchanged at 30. The 10-year dollar swap spread rose 1.25 to 46.25. Corporate bond spreads were again little changed for the week. The implied yield on 3-month December Eurodollars rose 4 basis points to 2.215%.

Freddie Mac posted 30-year fixed mortgage rates added one basis point this week to 5.82%. Fifteen-year fixed mortgage rates rose 2 basis points to 5.21%, which is about 110 basis points below the level from one year ago. One-year adjustable-rate mortgages could be had at 4.05%, up 4 basis points for the week. The Mortgage Bankers Association Purchase application index declined 5% last week. Purchase applications were up 19% from one year ago, with dollar volume up 31%. Refi applications declined 8%. The average Purchase mortgage was for $214,100, and the average ARM was $294,400. ARMs accounted for 32.1% of applications last week.

August 27 – Bloomberg: “Venezuela President Hugo Chavez said the country’s economy must move away from capitalism and large land holdings must be eliminated. ‘I call on private businessmen to work together with us to build the new economy, transforming the capitalist economic model into a social, humanist and equality economy. The time has come to accelerate the transformation. The revolution has just begun.’”

Currency markets remain treacherous. The dollar index gained 1.8%, while Latin American currencies were notably impressive. The Brazilian real, gaining 0.4%, traded to a 16-week high. The “commodity” currencies suffered, with the Norwegian krone down 3.5%, the Australian dollar 2.9%, the New Zealand dollar 2.8%, and the South African rand 2.7%.

Commodities Watch:

August 27 – Bloomberg (Pratik Parija): “China imported 115.9 million metric tons of iron ore in the seven months ended July, 37 percent more than in the year-earlier period…”

Commodities, especially the energy sector, this week gave back some of their strong gains. The CRB index dipped 2.2% this week, reducing y-t-d gains to 5.9%. With October crude sinking $3.54 to $43.18, the Goldman Sachs Commodities index declined 6.2% (year-to-date gains of 14.6%).

China Watch:

August 24 – Bloomberg (Samuel Shen): “China’s central bank Governor Zhou Xiaochuan said banks should keep up lending curbs because the economy needs to slow more and inflation hasn't abated. ‘The current economic expansion and inflationary pressure have not evidently eased,’ Zhou said in a speech to a meeting of financial regulators in Beijing yesterday…”

August 24 – Bloomberg (Lily Nonomiya): “Japan’s trade with China rose to a record $79 billion in the six months ended June 30, the Japan External Trade Organization said. Exports to China rose 36 percent to $35 billion… It was the sixth straight half-year of export gains… Imports rose 26 percent to $44 billion…”

August 26 – Bloomberg (Philip Lagerkranser): “Hong Kong’s exports surged to a record last month as the city’s ports handled more components bound for China and Chinese-made toys, clothes and computers en route to the U.S., Europe and Japan. Exports rose 17 percent from a year earlier…”

August 26 – The Wall Street Journal (Laura Santini): “The smart money is coming back to Asia. Giant hedge funds are piling into the region, opening trading outposts in Hong Kong and Singapore and recruiting homegrown hedge-fund managers to oversee assets and identify investment opportunities… Hedge funds, for their part, are coming in search of bigger returns. This year has proven particularly difficult for global macro funds…which bet on relative price movements in securities around the world.”

August 26 – Bloomberg (Julie Ziegler): “The World Bank, a global lender that advises developing nations on policy, is likely to raise its annual economic growth forecasts for East Asia in October, said Homi Kharas, the bank’s chief economist for the region. ‘This time around we’re seeing a much more broad based recovery,’ Kharas said… The bank in April forecast 6.3 percent growth this year and 5.9 percent in 2005 for the region, which excludes industrialized countries such as Japan. Kharas said both forecasts will likely be raised. Increased investment in China and other East Asian nations is now another pillar for growth, joining increases in exports and private consumption, Kharas said.”

August 26 – Bloomberg (George Hsu): “Taiwan’s export orders rose more than expected to a record in July as electronics manufacturers increased sales to China, the U.S. and Europe. Export orders -- indicative of shipments in one to three months -- rose 28 percent from a year earlier to $18.5 billion, matching June’s gain…”

August 26 – Bloomberg (Theresa Tang): “Taiwan’s M2 money supply growth in July rose 7.8 percent from a year earlier… M2 is the broadest measure of the island’s money supply. Taiwan’s money supply in May grew 8.6 percent, its fastest pace in almost five years.”

August 25 – Bloomberg (Daisuke Takato): “Japan’s large-scale home electronic appliance stores had their biggest monthly sales gain in 3 ½ years, as the Athens Olympics stoked demand for flat-panel televisions and a hotter-than-usual summer increased shipments of air conditioners, industry figures showed. Sales in July rose 9.8 percent…compared with a year earlier…”

August 27 – Bloomberg (Seyoon Kim): “South Korea’s inflation rate will exceed 4 percent this month, Finance Minister Lee Hun Jai said. Consumer prices may rise more than 4.5 percent from a year earlier and are expected to increase 0.8 percent to 0.9 percent from July…”

August 27 – Bloomberg (Jun Ebias): “The Philippine central bank expects the inflation rate to climb to as much as 6.6 percent this month, its highest in more than three years, because of rising oil prices, Deputy Governor Amando Tetangco said.”

August 25 – Bloomberg (Stephanie Phang): “Malaysia’s economy expanded at its fastest pace in almost four years in the second quarter as domestic demand grew and manufacturers raised production to meet overseas orders. The central bank said full-year growth will probably top its current forecast of 6 percent to 6.5 percent expansion. Gross domestic product expanded 8 percent in the three months to June from a year earlier, accelerating from 7.6 percent growth in the first quarter…”

August 24 – Bloomberg (Cherian Thomas): “India’s Prime Minister Manmohan Singh said the government will seek to ensure economic growth of 7 percent to 8 percent to generate jobs and help alleviate poverty as it presses ahead with economic change. ‘One of the basic principles of governance is a commitment to ensure the economy grows at least 7 to 8 percent per annum in a sustained manner for a decade or more,’ the prime minister said in New Delhi today…”

August 25 – Bloomberg (Ravil Shirodkar): “India’s inflation rate, which is at a 3 1/2 year high, is a concern, said Ratan Tata, chairman of the Tata Group and a member of the central bank’s board. ‘We must all be concerned about rising prices. We should not be overtaken by our desire to increase corporate profits by raising prices.’”

August 26 – Bloomberg (Jason Folkmanis): “Vietnam’s consumer prices rose this month at their fastest pace in more than eight years as food costs jumped… Consumer prices are 9.9 percent higher than they were in August last year, the biggest increase since December 1995…”

Global Reflation Watch:

August 26 – Bloomberg (Brian Swint): “The money-supply growth rate in the dozen euro nations, the European Central Bank’s gauge of future inflation, unexpectedly accelerated for a second month in July. M3 grew at an annual pace of 5.5 percent after expanding 5.4 percent in June…”

August 26 – Bloomberg (Gonzalo Vina): “U.K. home-loan approvals fell 9.9 percent in July from the month earlier, the British Bankers’ Association said, suggesting the housing market is beginning to cool. The number of mortgages approved dropped to 210,500, and were down 19.5 percent from July a year ago.”

August 25 – Bloomberg (Halia Pavliva): “Russia, the world’s largest oil producer, said gross domestic product expanded 7.4 percent in the first seven months of the year because of high oil prices, Interfax newswire reported.”

August 23 – Bloomberg (Halia Pavliva): “Russia, the world’s largest oil producer, said its trade surplus widened by more than a quarter in the first half of the year from the same period a year ago as oil prices rose. Russia’s trade surplus rose to $36.3 billion in the first half of the year, or 25.6 percent, from $28.9 billion in the same period a year ago… Exports rose faster than imports, increasing 25.2 percent to $78.6 billion, while imports increased 24.7 percent, to $42.3 billion… Crude oil shipments accounted for 28.4 percent of Russia’s overall exports in the first half of the year…”

August 25 – Bloomberg (Carlos Caminada): “Brazil’s current account surplus held close to a record in July, as world economic growth bolstered demand for Brazilian goods. The surplus in the current account, the broadest measure of a country’s trade in goods and services, was $1.81 billion in July compared with a record $2.06 billion in June and a previous record of $1.48 billion in May… Economic growth in the U.S., China, Argentina and other countries has kept demand for Brazilian goods close to record highs, helping sustain inflows into South America’s largest economy…”

August 23 – Bloomberg (Igor Munoz and Andrew J. Barden): “Chile’s economy expanded 5.1 percent in the second quarter from the year-earlier period, the Chilean central bank said… The expansion was faster than 4.8 percent year-on-year growth in the first quarter…”

August 26 – Bloomberg (Helen Murphy): “Colombia’s industrial output rose in June at its fastest pace in 15 months as manufacturers increased exports to neighboring Venezuela and local consumer demand boosted sales in an economy growing at its fastest since 1995.”

California Bubble Watch:

The California Association of Realtors (C.A.R.) reported July Existing Home median prices at $463,540, down slightly from June’s record but up 21.4% ($81,600) from July 2003. Prices were up 44% ($141,640) from July 2002. Sales volumes were up 7.4% from one year ago. “C.A.R.’s unsold inventory index, which measures the number of months needed to deplete the supply of homes on the market at the current sales rate, increased to more than a three-month supply for the first time in 17 months.” Condo median prices were also down about 1% from June but, at $369,670, were up 27.8% y-o-y. By region, High Desert prices were up 49.6% y-o-y, Palm Springs/Lower Desert 39.5%, Riverside/San Bernardino 37.4%, San Diego 35.3%, Monterey County 27%, and Los Angeles 25.8%. Prices in Sacramento were up 31.4% and Northern California 20.7%. And while y-o-y prices were up 30.7% in Orange County, the number of sales actually sank 28%.

U.S. Bubble Economy Watch:

Bloomberg (Terry Barrett) this afternoon released the updated tally of “Worldwide International Reserve Assets.” Total central bank Reserve Assets are up $650 billion, or 24.5% y-o-y, to $3.30 Trillion. Japan’s reserves were up 49% from a year earlier to $800 billion, China’s 36% to $471 billion, Taiwan’s 26% to $230 billion, Hong Kong’s 5% to $118 billion, India’s 40% to $114 billion, and Singapore 15% to $100 billion. Combined, these seven Asian central bank reserve positions were up $521 billion, or 35%, over twelve months to $2.0 Trillion.

Last week analysts and the media noted that international investors increased their June purchases of U.S. long-term securities to $71.8 billion. I did not read, however, that net buying from Japan accounted for about $29 billion ($158bn y-t-d), with another $21.5 billion coming from the Caribbean ($80.5bn y-t-d). I would caution that heavy purchases from these two major financial “centers” definitely do not represent a global endorsement of the attractiveness of U.S. “investment.” Rather, such trading is more akin to excess global dollar balances being funneled back to U.S. securities markets “by default.”

August 26 – Dow Jones (Campion Walsh): “U.S. banks and thrifts earned $31.2 billion in the second quarter, the second highest amount ever following a revised $31.8 billion in earnings in the first quarter, the Federal Deposit Insurance Corp. said Thursday. Bank and thrift earnings in the second quarter were propelled by strengthening loan demands at a majority of institutions but offset by higher expenses at a few large banks, the FDIC said.”

August 25 – Dow Jones: “About 80% of surveyed banks expect lending to mid-market businesses to rise by at least 10% over the next 12 months, according to a report by a U.S. banking association released Wednesday. Surveyed banks said they expect moderate-to-strong growth in loan originations over the next year, with the majority of growth likely to come from commercial real estate, lines and term loans, according to the survey by the American Bankers Association… ‘The economic environment is prime for increased commercial lending activity, and the mid-market is one of the fastest growing segments of the revived commercial lending market,’ ABA Chief Economist James Chessen said…”

Mortgage Finance Bubble Watch:

Freddie Mac posted a strong July. For the month, the company’s Book of Business expanded by $15.8 billion to $1.476 Trillion, a 13% annualized growth rate. Expanding the most since last October, Freddie’s Retained Portfolio increased $11.2 billion, or 20.8% annualized, to $656 billion. Following six months of slow growth, over the past three months Freddie’s Book of Business has expanded at a 13% rate and its Retained Portfolio at a 15% pace.

August 27 - “The Mortgage Bankers Association (MBA) today released its quarterly commercial and multifamily mortgage loan originations survey for the second quarter of 2004, showing continued growth in mortgage originations. Commercial mortgage bankers originated $33.2 billion, up by 17.4 percent ($4.9 billion) from the same quarter in 2003 and up 54.1 percent ($11.6 billion) from the first quarter of 2004. The large increase from the first quarter reflects the traditional cycle of low levels of first-quarter originations followed by a pick-up in the second quarter. ‘The second quarter extends a period of record capital flows to the commercial and multifamily real estate markets, and sets 2004 on pace to exceed 2003’s record origination volumes,’ said Doug Duncan, MBA’s chief economist and senior vice president.”

August 25 - McGraw-Hill Construction Dodge report: “New construction starts in July climbed 5% to a seasonally adjusted annual rate of $595.1 billion… July showed stronger activity for each of the construction industry’s main sectors, nonresidential building, residential building, and nonbuilding construction (public works and electric utilities). For the first seven months of 2004, total construction on an unadjusted basis came to $342.4 billion, 10% higher than the corresponding period of 2003.”

August 24 – “Sparked by continued low mortgage rates, buyers across all segments in Florida pushed July’s sales of existing single-family homes 15 percent above the previous-year mark, according to the Florida Association of Realtors. Statewide, a total of 23,554 homes sold last month compared to 20,503 homes in July 2003. In another sign of Florida’s robust housing market, the statewide median sales price also rose 15 percent to $186,700; a year ago, it was $162,600. In July 1999, the statewide median sales price for existing single-family homes was $101,800, representing an increase of about 83.4 percent over the five-year period, FAR records show.”

July Existing Homes Sales were reported about as expected at a very strong 6.72 million annualized pace. Sales were up 8.6% from July 2003, with y-t-d sales running 10.4% above last year’s record pace (and up 25% from July 2002). At $244,700, the average (mean) price was up 7.2% from one year ago. Calculated Transaction Value was up 16.4% from one year ago to $1.644 Trillion, 47% over two years (prices up 18% and sales up 25%), 63% over 3 years (prices up 28% and sales up 27%), and 95% over six years (prices up 48% and sales up 32%).

New Home Sales were reported at a much weaker-than-expected 1.134 million annualized rate. This was the slowest pace of sales since December and was actually down about 2% from July 2003, although sales were still up almost 30% from July 2001. Average (mean) Prices, however, were up 10.4% from one year ago to a record $274,200. Prices were up 26% from July 2002, 31% from July 2001, and 53% from July 1998. The Inventory of New Homes jumped another 16,000 to 393,000, with an increase from July 2003 of 15.2%.

Combined New and Existing Home Sales for July were up 6.9% from July 2003 to 7.854 million annualized. Year-to-date, combined Sales are running 10.8% ahead of last year’s record (7.185 million). Combined Calculated Transaction Value was up 15.0% from July 2003 to $1.96 Trillion (second only to June’s record $2.02TN), up 47% from July 2002, up 64% from July 2001, and up 96% from July 1998.

Bubble at the Fringe:

August 26 – The Wall Street Journal (rising star Christine Richard): “Real-estate investment trusts that invest in mortgage-backed securities are stepping up sales of debt securities to lessen what some see as a potentially dangerous over-reliance on borrowing from Wall Street firms. Mortgage-backed securities REITs take debt stakes in the residential real-estate market via mortgage-backed bonds. They are a variation on traditional REITs, which take equity stakes in commercial real estate. This type of mortgage-REIT model of investing in mortgage-backed securities and funding those purchases at low short-term rates has been highly profitable. But it relies heavily on a single funding source: repurchase agreements with Wall Street firms...”

The ongoing REIT Bubble is one to monitor closely. The 8 largest “mortgage REITs” I follow expanded combined assets at a 65% rate during the second quarter, to almost $124 billion. This puts first-half growth at an astonishing pace of 80%. Thornburg increased assets at a 57% rate during the first six months of the year to $24.5 billion. Redwood Trust assets expanded at a 49% rate during the first half to $22.0 billion. Annaly Mortgage expanded at a 65% pace to $17.2 billion. American Home Mortgage increased assets to $9.64 billion from $3.4 billion at year-end. Impac Mortgage Holdings assets surged from $10.7 billion to $17.0 billion in just two quarters. Over the same period, (soon to be REIT) New Century Financial’s assets jumped from $8.9 billion to $14.7 billion. Friedman, Billings, Ramsey expanded assets at a 35% rate to $13.3 billion, and MFA Mortgage grew assets at a 40% rate to $5.5 billion. And while not in the “top-tier,” Novastar Financial expanded assets at a 67% rate during the first half to $2.2 billion; Newcastle Investment grew assets at a 79% rate to $4.2 billion; Anthracite Capital at a 110% rate to $3.7 billion; and Anworth Mortgage at a 37% rate to $5.1 billion.

The mortgage REITs - aggressively tapping securities-based lending sources (mostly “repos”) to leverage mortgage holdings - provide an illuminating example of today’s key Credit system dynamics. At the margin, the REITs (and anyone else wishing to leverage MBS!) continue to enjoy unlimited access to inexpensive Wall Street borrowings that are then used to provide liquidity to the American homeowner. Total mortgage Credit is on pace to expand by more than $1 Trillion this year, and it is clear that highly leveraged players are a major force in financing this expansion (and creating “repo” and other non-deposit liabilities along the way). In the process, the “repo” market and mortgage finance are providing the commanding source of liquidity for the financial markets and economy.

About a month ago I titled a Bulletin “Trouble at the Core.” The gist of the analysis was that Monetary Disorder at the heart of the U.S. Credit system (specifically the Mortgage Finance Bubble “blow-off” and associated excess throughout “structured finance”) was over-liquefying the “periphery” of the global financial system (“emerging” markets and economies, in particular). As such, we should not necessarily expect the typical dynamic whereby financial stress unfolds initially with faltering liquidity for the “marginal” borrower (and lender). It comes to mind that I have not adequately addressed the corollary issue of Monetary Disorder at “The Core” similarly buttressing the Fringe players within the U.S. Credit system. Indeed, there is today a Boom at the Fringe.

Examining year-to-date stock performance, subprime Credit card issuer Metris has gained 82%. Advanta is up 71% and Providian 26%. Subprime auto lending is a hot ticket as well, with AmeriCredit and Credit Acceptance Corp sporting 2004 gains of 33% and 20%. WFS Financial has a 2004 gain of 8%. Smaller players have been in demand also, with Consumer Portfolio Services up 19% y-t-d and Onyx Acceptance up 38%. “Subprime” business lender American Capital Strategies has risen 7%. Mortgage lender New Century Financial has posted a 37% gain so far this year. Other notable gains in the financial arena include Countrywide Financial up 38%, Capital One 13%, and MGIC 22%.

I have in the past referred to subprime lenders (AmeriCredit, in particular) as the mine shaft “canary.” Well, AmeriCredit expanded assets at a 23% rate during the second quarter to $8.6 billion, the largest increase in a year (13% first-half growth rate). A booming securitization market (and attendant demand for high-yielding loans) has played the decisive role, as the company appears to have survived yet another faltering liquidity near-death experience. Yet, as it is with the U.S. economy generally and subprime lending especially, one can for some period grow out of bad loan troubles as long as ample liquidity engenders the funding of a large volume of new loans. Apparently – according to equity and debt investors – the current financial environment affords aggressive lenders exactly this type of opportunity.

Also apparently “pulling through,” subprime Credit card lender Metris expanded assets at a 13% rate during the first half, this after assets dropped by almost half during the previous year. Providian Financial assets expanded at a 3% rate during the second quarter to $13.6 billion, reversing 10 straight quarters of asset contraction (assets declining 37% over this period). Subprime auto lender Credit Acceptance Corp. assets expanded at a 16% rate during the first half to $1.02 billion. Subprime mortgage lender Accredited Home Lenders has a 25% stock gain so far this year, with assets having doubled during the first half to $5.4 billion. “Non-conforming” mortgage lender Saxon Capital (up 20% y-t-d) has increased assets at a 23% rate to $5.6 billion. Mortgage Bank IndyMac (up 17% y-t-d) has expanded assets at a 35% rate during the first half to $15.5 billion. And truly back from the dead (remember the fall of 1998?), Delta Financial has increased assets to $1.3 billion after ending 2003 at $257 million. Assets have jumped from $2.5 billion to $4.1 billion in six months at Municipal Mortgage & Equity, and from $2.6 billion to $5.5 billion at multifamily lender CharterMac.

American Capital Strategies (“arranges loans for and invests in small and medium sized businesses”) assets expanded at a 65% rate during the first half to $2.7 billion. Capital Source Inc. (“provides loans to small and medium-sized businesses”) expanded assets at a 75% rate during the first half to $3.5 billion. Fidelity National Financial (“provides insurance underwriting and diversified real estate services”) assets expanded at a 35% rate during the first half to $8.6 billion (stock up 5%). Investors Financial Services (stock up 21%) total assets expanded at a 37% rate during the first half to $10.9 billion.

While Credit Bubble analysis is very much “macro,” it is as well imperative to get right down to the nitty-gritty when it comes to examining borrowing and lending: who is lending to whom for what, and what liabilities are created in the process? There is today considerable evidence that Credit Availability is abundant throughout and, perhaps, even turning easier. Subprime lenders have been picking up their lending, while bank loan officer surveys suggest loose standards and a hankering to expand small and mid-market business lending. And, importantly, there is no indication of any tightening from historically ultra-easy lending standards throughout mortgage finance. If anything, the global rush for higher yields (and resulting boons for CDOs, Credit default swaps, and “structured products” generally) has become only more intense. There are today truly Booms at the Fringe and The Core.

But what is there to take away from this analysis? Well, it would be truly extraordinary (unprecedented?) for the economy to roll-over with such ultra-easy general Credit Availability and robust lending growth. At the same time, the economy is ominously less than impressive considering the extraordinary financial backdrop. Looking at the decline in rates over the past few months and, as well, factoring in the apparent heightened quest for risk assets, I will err on the side of expecting spending to be resilient through year-end (although this is an admittedly tenuous forecast). But how much will continued buoyant expenditures stimulate U.S. investments and hiring?

Data from the ports of Long Beach and Los Angeles do not bode well for U.S. economic prospects (or July’s trade deficit). Inbound containers into the Port of Long Beach jumped to 281,817, surpassing the previous record set in June by more than 21,000 containers. The Port of Los Angeles also set a new record for inbound containers, with July’s 361,584 slightly ahead of May’s record. Total Inbound containers were up 15% from one year ago to 643,401, while total loaded outbound containers were about unchanged at 178,382. Containers leaving the two ports empty surged 24% from July 2003 to 384,279, more than double those leaving loaded. Wow…

I recall reading articles highlighting noteworthy examples of spending extravagance that preceded by only months the respective crises in Mexico, Thailand, Russia, Brazil, and Argentina. But, then again, lavish purchases and ballooning trade deficits are a hallmark of Monetary Disorder. And while profligate spending is not a fresh development here in the U.S., I couldn’t help but to think that almost 400,000 empty cargo containers leaving the Los Angeles and Long Beach ports during July is a signal along the same lines as booming Mercedes sales were in Russia during 1998’s first half.

And I cannot also help but believe that “strong vs. weak U.S. economy” debates have basically become moot. What should be clear at this point is that even huge fiscal stimulus and unprecedented financial excess are incapable of fostering a sound and self-sustaining economic expansion. The paramount issue, today and going forward, is the deeply maladjusted U.S. economy and its increasing unresponsiveness to even enormous yet misdirected financial stimulus. Both the Financial Sphere and Economic Sphere are severely maladjusted. Two years of Fed-orchestrated “reflation” have only added to the U.S. economy’s inflated cost structure and further weighed on global competitiveness. Meanwhile, the Global Credit Bubble (and China and Asian booms, in particular) has worked to strengthen the capabilities (financial and economic) of our determined competitors.

But we should have expected nothing less. Today’s Bubble at the Fringe is but a further manifestation of historic Credit Bubble excesses that have inflated asset prices, bolstered consumption and imports, and inflated the general economy’s cost structure, while having limited impact on sound business investment. And I will stick with the analysis that today’s predicament of Monetary Disorder and Deep Structural Economic Imbalances is on course to precipitate some type of financial crisis. But, appreciating the extraordinary nature of current global financial systems and markets, it is anyone’s guess as to how long market “ebb and flow” can hold tumult at bay. We do know that the U.S. economy and markets require $2 to $3 Trillion of total annual Credit growth. Succinctly, there remain two overarching issues: First, how long can this amount of Credit creation be maintained? Second, what will be the nature of Inflationary Manifestations while the Credit Bubble is sustained?

Stocks came charging back. For the week, the Dow and S&P500 gained 3%. Economically sensitive issue performed well, with the Transports up 4% and the Morgan Stanley Cyclical index up 4.5%. The S&P Homebuilding index gained 4.5%, increasing year-to-date gains to 7%. The Morgan Stanley Consumer index rose 2.5%, and the Utilities added 1.0%. The broader market was quiet strong, with the small cap Russell 2000 jumping 6% and the S&P400 Mid-cap index up 4.3%. Technology stocks rallied sharply, with the NASDAQ100 up 4.5% and the Morgan Stanley High Tech index up 6%. The Semiconductors were up 5%, and the Street.com Internet index was up 6%. The NASDAQ Telecommunications index gained 7%. The Biotechs surged 10% for the week. Financials were also strong, with the Broker/dealers up 8% and the Banks up 3.5%. With bullion up $14, the HUI index gained 10%.

Bonds were impressive in the face of rallying equity markets. For the week, 2-year Treasury yields dipped 3 basis points to 2.43%. Five-year Treasury yields were down 1 basis point to 3.41%. Ten-year yields were unchanged at 4.23%. Long-bond yields ended the week at 5.03%, up 1 basis point on the week. Benchmark Fannie Mae MBS yields rose 2 basis points, again underperforming Treasuries. The spread (to 10-year Treasuries) on Fannie’s 4 3/8% 2013 note narrowed 1 to 32, and the spread on Freddie’s 4 ½ 2013 note narrowed 1.5 to 30.5. The 10-year dollar swap spread declined 1.25 to 45, the narrowest spread in four months. Corporate bond spreads were generally little changed for the week. The implied yield on 3-month December Eurodollars increased 0.5 basis points to 2.175%.

Convert issuance included American Tower $345 million and Aquantive $70 million.

Japanese 10-year JGB yields were about unchanged for the week at 1.56%. Brazilian benchmark bond yields sank another 22 basis points to 9.77%, with yields down about 100 basis points over four weeks. The Brazilian real enjoyed its fourth straight weekly gain against the dollar. Mexican govt. yields dropped 11 basis points this week to 5.40%, the lowest yields since April 16. Russian 10-year Eurobond yields dipped 4 basis points to 6.36%.

Freddie Mac posted 30-year fixed mortgage rates declined 4 basis points this week to 5.81%, with rates down 27 basis points in four weeks to the lowest level in more than four months. Fifteen-year fixed mortgage rates fell 5 basis points to 5.19%, down 30 basis points in three weeks. One-year adjustable-rate mortgages could be had at 4.01%, down 7 basis points for the week. The Mortgage Bankers Association Purchase application index rose 6.2% last week. Purchase applications were up 20% from one year ago, with dollar volume up almost 35%. Refi applications jumped about 21% to the highest level since the first week of May. The average Purchase mortgage was for $219,500, and the average ARM was $298,100. ARMs accounted for 33.6% of applications last week.

Treasury Undersecretary John Taylor responding to questions on Bloomberg television: “In fact, Germany is about the only part of the world where things are not pretty strong and steady right now.”

Bloomberg’s Erin Burnett: “Another part of the world where some would say things are not strong and steady is right here at home in the United States. The United States (has) a record trade deficit; the current account at another record. Even over at the Fed, we’ve started to hear some signs that they are concerned about these numbers. Is that concern fair?”

Treasury Undersecretary John Taylor: “The current account deficit we have reflects how much investment opportunities there are here in the United States. America is an attractive place for foreigners to invest. That creates this deficit between investment and saving, and as long as our productivity growth is strong, as long as we have a strong economy – and we want to get it strong and we want to create more jobs – then it is going to be an attractive place for foreigners to invest. And that’s really the source of this deficit. Of course you want to continue to make the United States attractive – continue to try to find ways to raise saving and create more jobs in the United States. But right now, I think we’ve got this steadiness and sustainability of the economy which is so valuable to have, so you prevent the kinds of recessions and slowdowns that occurred in 2000.”

Bloomberg’s Erin Burnett: “So right now, what region are you most concerned about. If you had to pick a region - you even had to pick a country that you think is the biggest problem you are focusing on right now overseas. What is it?”

Treasury Undersecretary John Taylor: “There’s no single country. Right now – again I would emphasize the balance – emerging market spreads – that is the spreads between the interest rate that emerging market countries have to pay and U.S. Treasuries – is remarkably low. It’s as low as it’s been for a long time. There doesn’t seem to be that kind of contagion we saw in the 1990s. There’s no major financial market crisis right now. Remember the nineties. You had the Asian crisis, you had the Russian crisis, you had the Tequila crisis. Right now we’re in the situation were there’s no real major crisis, and that’s good. But you’ve always got to be on the lookout. And I think there’s no single place to look for that lookout. You look a little bit at Asia, you look in Latin America. You want the countries of the world that are not doing so well to grow faster. And there you have some in Africa, the Middle East. More economic success in those areas would be very, very welcome.”

Currency Watch:

The “commodity currencies” were strong this week. The Brazilian real gained almost 2%, with the Chilean peso, Australian dollar, New Zealand dollar, and Canadian dollar all up about 1%. The yen gained 1.34 %. The British pound declined 1.4% and the South African rand 1.56%. The dollar index posted a small gain for the week.

Commodities Watch:

August 20 – Bloomberg (Rob Delaney): “China’s crude oil imports rose 41 percent to 9.6 million metric tons in July compared with a year earlier, according to customs data. China’s crude oil imports in the first seven months of the year rose 40 percent to 71 million tons, it said.”

August 20 – Bloomberg (Meggan Richard and Hector Forster): “Japan’s electricity sales rose for a fifth consecutive month in July, gaining 12.5 percent because record summer weather increased use of air conditioning, the Federation of Electric Power Companies of Japan said.”

August 18 – Bloomberg (Claudia Carpenter): “Lumber prices in Chicago rose to the highest in 10 years as Florida’s homeowners and businesses rebuild after Hurricane Charley, the second most-destructive U.S. hurricane after Andrew in 1992. Lumber futures for September delivery rose $15, the maximum allowed by the Chicago Mercantile Exchange, to $442 per 1,000 feet of two-by-fours, the highest for a most-active contract since March 1994. The 3.5 percent gain was the biggest in seven months. Before Friday, lumber prices gained 36 percent in the past year as North American housing demand surged.”

August 20 – Bloomberg (Thomas Black): “Florida’s efforts to rebuild from the destruction of Hurricane Charley probably will exacerbate a year-long shortage of cement in the state and slow construction, according to Cemex SA, the biggest producer in the Americas. Cement demand exceeded supply by as much as 20 percent before last week’s storm…”

Gold today posted its highest close since April 12. The CRB index jumped 2.7% this week (y-t-d gains of 8.3%). And despite today’s reversal and 92 cent decline, October crude rose 69 cents this week to a record $46.72. The Goldman Sachs Commodities index added 1% for the week, increasing year-to-date gains to 22.2%.

China Watch:

August 18 – Bloomberg (Philip Lagerkranser and Tian Ying): “Investment in China’s factories, roads and other fixed assets rose 31 percent in the first seven months of this year, suggesting government lending curbs failed to cool industrial expansion in July. The increase, which took the investment tally for the year to 2.71 trillion yuan ($327 billion), matched the gain for the first half, the Beijing-based National Bureau of Statistics said… That indicates July’s increase exceeded June's 23 percent gain.”

August 18 – Bloomberg (Joshua Fellman): “China’s rising rural incomes are creating a labor shortage at factories in Guangdong province, the country’s manufacturing hub, as migrant workers stay home, according to executives at companies… Manufacturers in Guangdong -- a province bordering Hong Kong where factories churn out goods for companies including Wal-Mart Stores Inc. and Nike Inc. -- have relied on a steady flow of laborers from China’s interior to produce cheap exports. They’re now under pressure to raise wages to lure workers, threatening to curb cost savings, lift export prices and stoke inflation that's already at a seven-year high. Incomes in rural China -- home to about 60 percent of the country’s 1.3 billion people -- rose 16 percent in the first half from a year earlier…”

August 19 – Bloomberg (Jianguo Jiang): “China’s property prices grew at their fastest pace since 1996 in the first seven months of this year, suggesting government lending curbs have failed to rein in an investment boom in the industry. Residential and commercial prices rose 12.9 percent from a year earlier in the January-July period, after climbing 11.6 percent in the first half, the Beijing-based National Bureau of Statistics said… Investment climbed 29 percent, matching the gain for the first half.”

August 19 – Bloomberg (Philip Lagerkranser and Le-Min Lim): “Foreign direct investment in China rose in the first seven months as companies including Siemens AG and Ford Motor Co. expanded to take advantage of low wages and tap rising demand… Investment from abroad increased 15 percent from a year earlier to $38.4 billion in the seven months through July after gaining 12 percent in the first six months, the Beijing-based Ministry of Commerce said… Contracted investment, a sign of future investment, rose 40 percent to $82.7 billion.”

Asia Inflation Watch:

August 20 – Bloomberg (Issei Morita): “Sales at Japan’s convenience stores rose a record 6.8 percent in July from the same month last year as customers bought more ice cream, soft drinks and cold noodles amid higher summer temperatures.”

August 17 – Bloomberg (Kartik Goyal): “India’s exports rose 19 percent in July from a year earlier as automobile companies shipped more to overseas markets and steel companies stepped up sales to China. Exports were $5.43 billion last month… Imports rose 32 percent to $7.43 billion, boosted by higher oil costs. The trade deficit widened to $2 billion from $1.07 billion in July last year.”

August 20 – Bloomberg (George Hsu): “Taiwan raised its 2004 economic growth forecast after record exports and surging investment helped the economy expand at its fastest pace in more than four years in the second quarter. Gross domestic product rose 7.7 percent from a year earlier in the April-June period after climbing a revised 6.7 percent in the previous three months, the statistics bureau said… The government raised its full-year growth forecast to 5.9 percent, which would be the fastest expansion since 1997.”

August 17 – Bloomberg (Amit Prakash): “Singapore’s exports rose more than expected in July as companies such as Chartered Semiconductor Manufacturing Ltd. and Pfizer Inc. shipped more computer chips and drugs to the U.S., China and Europe. Non-oil domestic exports gained a seasonally adjusted 2.6 percent from June, after shrinking 6.9 percent that month… From a year earlier, exports rose 17.6 percent….”

August 18 – Bloomberg (Khoo Hsu Chuang): “Malaysia’s vehicle sales rose more than a fifth in July to their highest this year as consumers, buoyed by a strengthening economy, bought more cars. Sales of passenger cars and commercial vehicles rose 22 percent from a year earlier…”

August 16 – Bloomberg (Shanthy Nambiar and Amit Prakash): “Indonesia’s economic growth slowed more than expected in the second quarter as government spending fell and inflation curbed household purchases. Record oil prices may slow expansion further this quarter, the government said. Southeast Asia’s biggest economy expanded 4.3 percent from a year earlier in April through June, after growing a revised 5 percent in the first quarter…”

August 19 – Bloomberg (Francisco Alcuaz Jr.): “Philippine imports rose in June at their fastest pace in more than a year as high oil prices increased the cost of the nation's fuel purchases from abroad. Imports increased 18 percent to $3.46 billion, the National Statistics Office said in Manila. That was the biggest gain since February 2003…”

August 16 – Bloomberg (Francisco Alcuaz Jr.): “The Philippine economy expanded as much as 6 percent in the second quarter as manufacturing and services picked up, according to official estimates.”

August 16 – Bloomberg (Katia Cortes): “Philippine inflation may average more than the government's 5 percent limit this year, an official said at a press briefing in Manila. ‘In 2004 we now have the possibility of breaching the upper end,’ Assistant Economic Planning Secretary Gay Cororaton said…”

Global Reflation Watch:

August 19 – Bloomberg (Reed V. Landberg): “U.K. banks and building societies provided home loans at a record rate in July, reflecting the strength of the housing market and consumers’ desire to lock in borrowing costs as interest rates rise, the Council of Mortgage Lenders said. Banks and building societies loaned 29.2 billion pounds ($53 billion) in mortgages last month, up 3 percent from June and 13 percent higher than a year ago…”

August 17 – Bloomberg (Gonzalo Vina and Duncan Hooper): “U.K. house prices grew at their slowest pace in a year in July and the number of property sales fell for a fourth consecutive month, as higher borrowing costs begin to cool demand, the Royal Institution of Chartered Surveyors said.”

August 17 – Bloomberg (Vladimir Todres): “Russia attracted 35 percent more foreign direct investment in the first half than in the year-earlier period as the country’s businessmen continued bringing home money they parked in offshore havens… Direct investment totaled $3.43 billion in the first half, the Federal Service of State Statistics said… Total foreign investment, including portfolio investments and loans, rose 50 percent to $19 billion…”

August 20 – Bloomberg (Halia Pavliva): “Russia’s retail sales increased 12.3 percent in July from the same month a year ago, faster than expected, as the growing economy expanded domestic demand, the State Statistics Service said.”

August 19 – Bloomberg (Vladimir Todres): “Russia’s foreign currency and gold reserves probably will rise to $100 billion by the end of the year, central bank Chairman Sergei Ignatyev said. Higher-than-expected oil prices have accelerated the growth in Russia's reserves, Ignatyev said in Moscow. Russia’s foreign currency and gold reserves rose to a record $89.6 billion in the week to Aug. 13…”

August 19 – Bloomberg (Tina Morrison): “New Zealand house price increases slowed for a third quarter in the three months ended June 30… The national house price index provisionally rose 1.9 percent in the second quarter following a revised 5 percent increase in the three months ended March 31… From a year earlier, prices rose 22 percent.”

August 18 – Bloomberg (Nick Benequista): “Mexico’s economy grew in the second quarter at its fastest pace since 2000 on resurgent demand from the U.S. for the country’s electronics, oil and metals. Mexican gross domestic product, the broadest measure of output of goods and services, grew 3.9 percent from the same period last year after expanding 3.7 percent the previous quarter…”

August 18 – Bloomberg (Romina Nicaretta and Jeb Blount): “Brazilian retail sales rose at their fastest pace in at least three years in June as falling unemployment boosted sales of food and declining rates on consumer loans increased sales of furniture and appliances. Retail, supermarket and grocery store sales, as measured by units sold, rose 12.8 percent from the year-earlier period after increasing 10 percent in May…”

August 17 – Bloomberg (Katia Cortes): “Brazil’s federal tax revenue rose 20 percent in July from a year earlier, as a stronger economy led more people to pay taxes and the government increased social security contributions from companies.”

California Bubble Watch:

August 18 – Los Angeles Times (Annette Haddad): “Last month, for the first time in seven months, the pace of home-price appreciation in Los Angeles County finally slowed down. The median price clocked in at $406,000, only a 23.8% increase from July 2003… And to some, even the tiniest dip in a housing heat wave statistic spelled relief. The July numbers ‘may be an indication that the market is cooling a little bit,’ said John Karevoll, chief analyst with DataQuick… ‘But when you say ‘cooling,’ it’s like the surface temperature of the sun cooling a notch.’”

August 18 – San Diego Union-Tribune (Lori Weisberg): “When the median price of a resale home in San Diego County hit $500,000 for the first time, the question arose: What does half a million dollars buy these days? The answer: a 720-square-foot 1920s charmer in South Park, a gentrifying neighborhood five minutes from downtown San Diego. That was in May. The home is about to close escrow this week, selling for $497,000 – $18,000 under the initial $515,000 listing price. While the two-bedroom, one-bath home stayed on the market for 39 days, the sellers still were able to capture a profit of $220,000 on a home they bought three years ago. The median price of a resale home has since jumped to $520,000, making it increasingly harder for aspiring buyers to purchase a piece of the American Dream in San Diego County.”

August 18 – AP: “Hundreds of thousands of applicants are competing for 3,000 temporary jobs at the ports of Long Beach and Los Angeles, hoping for lucrative wages in an otherwise weak labor market. The jobs, which pay $20 to $28 an hour, were created to handle a record amount of cargo coming through both ports. A Long Beach post office spokesman said Tuesday that a conservative estimate put the number of mailed-in applications at 220,000 to 250,000.”

U.S. Bubble Economy Watch:

August 19 – New York Times (Eduardo Porter): “A relentless rise in the cost of employee health insurance has become a significant factor in the employment slump, as the labor market adds only a trickle of new jobs each month despite nearly three years of uninterrupted economic growth. Government data, industry surveys and interviews with employers big and small indicate that many businesses remain reluctant to hire full-time employees because health insurance, which now costs the nation's employers an average of about $3,000 a year for each worker, has become one of the fastest-growing costs for companies. Health premiums are sapping corporate balance sheets even more than the rising cost of energy. In the second quarter, the cost of health benefits rose at a 12-month rate of 8.1 percent - more than three times the inflation rate and the rate of increases in wages and salaries… The increase in health insurance premiums reflects the rising cost of health care, which is being driven by expensive new drugs, many of them heavily advertised to consumers; medical advances including diagnostic tests that require costly new machines; and a reaction to past restrictions in managed care health plans that sought to rein in costs.”

August 18 - Dow Jones (Janet Whitman): “Spending on advertising in the U.S. rose 6.4% in the first half of the year to $49.6 billion, lifted by increased political advertising and a rise in demand from traditional advertisers… The top 10 advertisers spent $8 billion on advertising this year through June, an 11.3% increase from the same period a year ago…”

August 17 – Market News International (Steve Beckner): “A Federal Reserve survey of banks released Monday found conflicting indications on credit conditions for companies and households over the past three months. In a potentially positive sign for the economy the Fed’s quarterly senior loan officer survey found demand for all types of business loans increased significantly over the past three months. But despite somewhat eased terms for households, lending to that sector generally weakened. At the same time banks indicated a greater willingness to make business loans by further easing loan terms and standards.”

August 19 – Market News International (Gary Rosenberger): “Demand for new trucks is back to levels unseen in five years, pushed up by a robust manufacturing recovery, a massive import surge, a delayed replacement cycle, and a railway system beset by severe capacity constraints, truck industry officials say. Factories are pushing out new trucks as fast as they can but supply constraints are extending lead times anywhere from three months into early next year, slowed by shortages of engines, axles, steel and other components and raw materials, the officials say. Strong demand and higher input costs are raising prices at wholesale -- factories have instituted non-negotiable raw material surcharges valued at between $3,000 and $5,000…”

August 16 – BusinessWire: “Factory-to-dealer deliveries of recreation vehicles (RVs) are up 20 percent for the first half of 2004 compared to the same period last year--on pace to set a quarter-century record, according to newly released data from Recreation Vehicle Industry Association (RVIA).”

Mortgage Finance Bubble Watch:

Both July Housing Starts and Permits were much stronger-than-expected. Total Housing Starts were reported at an annualized rate of 1.978 million, up sharply from June’s 1.826 million. Total Starts were up 4.5% (single-family up 7.5%) from July 2003 and 38% from July 1997. Single-family Starts were up 22.8% from July 2003. Total Building Permits were reported at 2.055 million annualized, up from June’s 1.945 million and compared to the consensus estimate of 1.95 million. Permits were up 9% from last July and up 43% from July 1997. At 1.234 million units annualized, Homes Under Construction were up 14.5% from the year ago period to a new record (up 48% from July 1997).

Golden West Financial reported record originations of $4.9 billion during July, up 54% from July 2003. Loans expanded at a 35% rate during the month to $91.7 billion and were up 32% from one year ago. On the liability side, Borrowings from the FHLB have expanded at a 66% rate over the past four months and were up 31% from July 2003. Deposits have expanded at a 15% rate over the past four months and were up 9% over 12 months. Ninety-nine percent of July originations were ARMs.

A stronger June was followed by a slow July at Fannie Mae. The company’s Total Book of Business expanded at a 2.6% rate to $2.256 Trillion, with a y-t-d growth rate of 4.5%. Fannie’s Retained Portfolio expanded at a 2.0% pace to $892.7 Trillion.

Fannie Mae chief economist David Berson revised higher his estimates for 2004 New and Existing Home Sales, as well as net mortgage lending growth. The Mortgage Bankers Association (MBAA) this week also revised 2004 forecasts higher, including Housing Starts, New and Existing Home Sales and Median Prices. Comparing recent MBAA forecasts to those made in late January, it is worth noting that estimates for New Home Sales for the year have increased 18% and Existing Home Sales 10%. The forecast for 2004 Single Family Starts has risen 10%. Third quarter New Home Median Prices have been revised 7% higher and Exiting Home Prices 2% higher.

Pondering Nuances of Contemporary Speculative Finance:

August 18 - Dow Jones (Michael Mackenzie): “The desire to chase better returns in a low yield environment is driving already strong demand for structured credit derivative deals. Not surprisingly, hedge funds, who usually stand to reap 20% of the profits they make for clients, are leading the way. Underperforming hedge funds are looking to load up on credit risk via collateralized debt obligations or the fast maturing high yield debt market, say credit derivative traders. Whether the strategy backfires or pays off depends on how risky corporate borrowers fare over the coming quarters as the Federal Reserve hikes interest rates into what appears to be a decelerating economy… So for hedge funds not faring well, a choice looms between making bigger sized bets or increasing their appetite for high yield, or riskier corporate credit, said a credit derivatives trader at an investment bank in New York. ‘The underperforming guys face having to take a swing at the market.’ As a result, demand for higher exposure to such debt via collateralized debt obligations - built upon credit default swaps - has been buoyant in recent months.”

The New York Times this morning reported that Barton Biggs’ Traxis Partners has posted losses this year (down 7% through July), “partly because of a bearish bet on the price of oil…” There seems to be little doubt that some speculators and derivative players have faced a painful squeeze as energy prices have surged higher. A few analysts have argued that commodity prices were being pushed artificially upward by speculative buying. That said, there have as well been significant bearish bets placed – oil and gold, for example – whose unwind supports higher prices. Welcome to the Unstable World of Speculative Finance.

I would conjecture that Mr. Biggs succumbed to placing a wager on lower crude prices because he lacked conviction as to how stellar returns could be achieved elsewhere for his $2 billion hedge fund. Coming into the year, the bond market offered an unattractive risk/return profile, and prospects for equities were dicey at best. Commodities had already made a major move, with the near-term outlook especially uncertain. Yet poor return prospects did nothing to slow the torrent of liquidity flowing into the speculative community. And for many speculators that have been stung this year by bad bets (i.e. technology stocks and interest-rates), there is now the inclination to reach for stronger returns (and risk) wherever they can be garnered. The CDO (collateralized-debt obligations) and Credit default swap markets (see the excerpt from the Dow Jones story above) fit the bill, augmenting already ultra-easy Credit Availability.

Similar to writing catastrophic risk insurance policies, Contemporary Finance does empower a speculator with the opportunity to enjoy the fruits of receiving large risk premiums, all the while hoping that inevitable losses are delayed for at least a few years (earning 20% of “profits” along the way). However, the problem with a boom in writing Credit insurance (or “flood” protection) is that the resulting Credit boom ensures both financial and economic distortions, along with eventual busts.

I find the nature of speculative finance absolutely fascinating. I have done battle and studied speculative dynamics on the short-side now for almost 15 years. In the process I have witnessed innumerable spectacular squeezes (including the historic technology and Internet melt-ups during 1999/early 2000) followed generally by rather abrupt and often only more spectacular collapses. Speculative Bubbles do create their own liquidity, although long periods of liquidity over-abundance can end quite suddenly. And now - as shorting myriad securities, instruments, commodities, and markets has become such a prominent aspect of contemporary, securities-based finance - I do ponder the ramifications with respect to systemic stability.

Examining the mechanics of an equity short position will hopefully provide some basic insight. To short a stock, we must first call the stock loan department at our prime broker. Shares are borrowed from a pool of available securities (from institutions seeking extra remuneration, or perhaps holders that purchased their shares on margin). These borrowed shares are then sold into the marketplace. A couple of additional facets of this simple example are worth noting. First, additional shares circulating in the marketplace (“float”) are created by selling borrowed securities, and a heavily shorted stock could experience a significant increase in outstanding “float.” Second, proceeds from the short-sale are segregated into a restricted account at the brokerage (to be invested in money market-type instruments). The sale of borrowed securities creates (after settlement) immediately available funds at the brokerage.

Conceptually, it would seem that shorting stock – because of the selling pressure and the creation of an additional supply of shares - would weigh on the stock price. At the same time, selling additional shares would seem to impinge marketplace liquidity. But, as is often the case in life, things are generally not as simple as they appear.

First of all, despite an increase in the supply of shares, market dynamics often dictate upward pressure on shorted stocks. Markets are, after all, truly an ongoing battle between greed and fear. If a heavily shorted stock continues to rise, the longs will be emboldened while the shorts will fear escalating losses. The actual supply/float may play a less than important role in determining short-term prices. Rising asset prices generally create their own speculative demand, often irrespective of supply. And when a heavily shorted stock surges higher, keep in mind that there are greater quantities of inflating shares and a larger amount of perceived wealth creation.

As for system-wide liquidity, shorting can have divergent and unexpected impacts. First of all, proceeds from the short-sale are placed in restricted accounts and these funds are then used to purchase short-term liquid instruments, including asset-backed securities and “repos”. As such, funds from short-sales provide a source of additional finance elsewhere, including for speculative purposes. In addition, unfolding “short squeezes” will commonly attract keen speculative interest. Aggressive long positions will be taken, often with leverage (augmenting system liquidity).

Contemporary finance and derivatives also provide a (too) convenient mechanism with which to handily satisfy the impulses of either greed or fear. Options and other derivatives certainly were a major factor in fueling the technology “blow-off.” On the one hand, they provided highly leveraged instruments whereby one could easily participate in the parabolic rise on the long side (and, at the time, who wasn’t hankering to do that!). On the other hand, options and derivatives were also used (sometimes in desperation) to mitigate disastrous bearish short positions that were being squeezed (to the moon). In either case, rising prices forced the writers of these instruments to implement leveraged long positions to hedge escalating risk. And, all the while, liquidity flush technology companies were buying back their stock and often dabbling in the derivatives market.

The upshot was a self-reinforcing speculation and liquidity melee that propelled a period of acute Monetary Disorder. Securities market dynamics had come to marshal a massive liquidity bulge that was both destabilizing and unsustainable. From stratospheric “blow-off” over-valuation, prices and speculative dynamics eventually reversed. And with the bursting of the Bubble, inflated quantities of shares trading in the marketplace, huge leveraged speculative long positions, and massive derivative-related leverage provided a powerful confluence of forces that assured collapse. As it was, it took only a few short months for a manic and historic Bubble to give way to a devastating marketplace illiquidity and an industry bust.

A strong argument can be made today that shorting, derivatives, leveraging and speculative dynamics have taken firm hold throughout the largest market in the world - the U.S. Credit market. And while I certainly cannot profess to understand and appreciate the various facets of this most opaque and complex marketplace, I do strongly believe that market dynamics have once again fostered a massive destabilizing liquidity bulge – a bulge that is over-liquefying various markets and keeping global market rates at artificially low levels (and in the process, accommodating and exacerbating dangerous imbalances).

According to most recent Fed data, primary dealer “repo agreements” have almost reached $3.0 Trillion. These securities financing arrangements are up an astonishing $446 billion over the past year, an 18% increase. The only comparable growth throughout the world of finance is the approximate $690 billion, or 27%, y-o-y increase in global central bank currency reserve positions. And I certainly do not view these two Bubbles as unrelated coincidences. Massive Credit market leveraging (of which the “repo” market is likely the most significant) is the instrumental source of excess domestic and global liquidity that is then (buyer of last resort) “monetized” and “recycled” right back into U.S. securities markets.

I have little doubt that the “repo” market and ballooning central bank balance sheets are at the epicenter of today’s unwieldy liquidity creation. Yet the specifics are not easily comprehended. There are, after all, many extraordinary facets to the analysis of contemporary liquidity, including the predominance of the securities markets (as opposed to traditional bank lending and “money” supply).

Let’s ponder a few examples. For example #1, the Bank of Japan purchases newly issued notes from the U.S. Treasury. Treasury uses this liquidity to pay government employees year-end bonuses. Government workers then use these bonuses to fund their pensions and buy imports. The liquidity is then quickly directed right back to U.S. securities markets, perhaps completely bypassing the monetary aggregates, while providing the impetus for additional credit creation and securitization.

For example #2, a hedge fund borrows and shorts Treasuries and then uses sales proceeds to take a leveraged position in mortgage-backed securities (MBS). Here, unlike when proceeds from equity short positions were segregated into restricted accounts, a good hedge fund client can use the funds generated from Treasury shorts to acquire higher-yielding securities (MBS, agencies, corporates, CDOs, junk, emerging market debt, etc.) And in this example, the Bank of Japan purchases the Treasuries (using dollar balances exchanged for yen with Toyota’s Japanese bank). Having bought new MBS from the proceeds of the Treasury short sale, the hedge fund transaction provided liquidity to Countrywide to make additional mortgage loans. These additional mortgage loans provided the finance for consumers to sustain consumption, including the acquisition of more Toyota and Lexus vehicles. And liquidity goes round and round…

Note that central bank Treasury purchases create liquidity for the risk-taking hedge fund (and, more generally, the Leveraged Speculating Community) and then the MBS marketplace, thus creating new Credit/purchasing power for the household sector. This liquidity could then flow right back to Toyota, the Bank of Japan, the hedge fund community, the MBS marketplace and/or the American consumer. Liquidity expands unrestrained right along with the increase in marketable debt (increasing quantities of MBS and Treasuries “float”). And with rapid mortgage Credit growth fueling the economy and home prices (keeping Credit losses minimal), the attractiveness of the spread trade – shorting Treasuries and buying MBS – only increases over time. The Great Mortgage Spread trade balloons over the years.

Let’s ponder a more complex example: Here, a hedge fund uses “repo” financing to take two $1 million leveraged positions in mortgage-backeds. In this example, there are six players: the hedge fund, the securities dealer, a pension fund, an MBS trust, Bank of Japan, and household sector. First, the securities dealer borrows $1 million of bonds from the pension fund. The dealer then shorts these Treasuries, selling them to the Bank of Japan. The dealer then uses this liquidity to finance the hedge fund’s MBS “repo.” The hedge fund then purchases mortgage-backeds held by the pension fund. The pension fund, now with $1 million of immediately available funds, chooses to invest these funds temporarily in money market instruments. In this example, these funds are borrowed by the securities dealer, and immediately lent to the hedge fund as it acquires $1 million of new MBS from MBS Trust. This purchase provides liquidity for the Trust to acquire additional mortgages from mortgage brokers across the country, providing the liquidity to finance additional household borrowing and spending (and more trade deficits and foreign central bank securities purchases). And as long as speculative leveraging expands, the economy grows, interest-rates remain low, and foreign demand for U.S. securities is sustained, liquidity will be abundant throughout the entire Credit system.

In a world of Debit and Credit journal entry Contemporary Finance, securities finance – whether it is through shorting Treasuries or borrowing in the “repo” market – creates seemingly endless system liquidity. Liquidity and Credit excess work to seductively underpin the value of the underlying securities. Liquidity empowers the issuance of additional marketable securities, and securities leveraging exacerbates liquidity excess. And that is why they are called Bubbles. And, in similar dynamics to the short squeeze example examined above, the increasing supply of securities and leverage in the marketplace remains seemingly benign, at least as long as the price of these securities is not declining.

Today, massive trade deficits foster unprecedented foreign Treasury buying. Domestically, a steep yield curve and heightened systemic risk boost demand for Treasuries. Indeed, there is today a virtually insatiable appetite for Treasury securities. This dynamic is quite accommodative for speculator funding of higher-yielding risky securities through government bond short-sales. And these transactions then create abundant liquidity that is dispersed throughout the Credit system, in the process sustaining the Credit and economic Bubbles.

But acute demand for Treasuries in the face of a massive and growing short position does create a rather volatile mix of unpredictable market dynamics - including inherent volatility and acute short squeeze vulnerability. And contemplating my experience with short squeezes, it is fascinating how they often go “parabolic” right when it should be apparent that fundamental deterioration is accelerating. This was conspicuously the case in early 2000 for the Internet, telecom and technology sectors. Indeed, negative fundamental developments encourage short sales and hedging, although market dynamics often dictate that the bulls and “greed” inertia maintain the upper hand in the marketplace well beyond the point when fundamentals have turned south.

Understandably, with the dollar sinking, energy prices surging, inflation rising, market rates extraordinarily low and demand for mortgage Credit exceptionally strong, many hedges were implemented to protect against higher rates (especially in the mortgage arena). And, wouldn’t you know it, the imbalanced U.S. Credit system and economy have proved incapable of generating robust job creation and expected (balanced) economic performance. The hyper-sensitive Treasury market (over-liquefied markets and insatiable demand for govt. debt) have rallied, and it would appear a major short squeeze has developed. It is again worth noting that the terminal “blow-off” technology squeeze and resulting final liquidity bulge sealed the fate for much of the industry. Similar dynamics are now in play throughout mortgage finance.

Disclaimer:

Doug Noland is not a financial advisor nor is he providing investment services. This blog does not provide investment advice and Doug Noland's comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. The Credit Bubble Bulletins are copyrighted. Doug's writings can be reproduced and retransmitted so long as a link to his blog is provided.